THE PRINCIPAL-AGENT PROBLEM PAPER

AN ANALYSIS OF THE PRINCIPAL-AGENT PROBLEM

 

Most analysis of the principal-agent problem presumes that the principal selects a risk-sharing proposal to maximize anticipated utility subject to the agents’ utility being at a constant point.

If the agent’sfirst choices over income risk are independent of action then the optimal way of applying an action by the agent can be established by solving a convex indoctrination problem (Sanford & Oliver, 1983).

Introduction

The procedure followed is to presume that the principal selects the incentives scheme, to maximize his expected utility subject to the constraints that:(a) the agent’s anticipated utility is no lesser than some pre-specified stage; (b) the agent’s utility is at a motionless point, i.e., the agent satisfies his first-order conditions with respect to the choice of action. That is, the agent’s second-order conditions (and the condition that the agent should be at a global rather than a local maximum) are ignored. Mirrlees [10], however, in an important paper, has shown that this procedure is generally invalid unless, at the optimum, the solution to the agent’s maximum problem is unique. In the absence of uniqueness (and it is difficult to guarantee uniqueness in advance), the first-order conditions derived by the above procedure are not even necessary conditions for the optimality of the risk-sharing contract.3

 Principal-agent problem

This paper describes how principal-agent; factors into production and profitability and also explores the merits and demerits of running one’s own company or hiring employees (Grossman & Hart, 2010). There exist many formal business settings whereby one economic actor – the principal, delegates authority to an agent to act on his or her behalf. The main reason for doing so is because he believes that the agent has the required skills and expertise or information in which, the informational advantage or the information asymmetry, is an eminent problem for the principal(Miller, 2005).

Having owned Dental care (agent), a patient (principal) prescribed for an expensive original drug considers the drugs to be expensive and of profit beneficial to the dentist. In this case, the patient cannot guarantee that the dentist is acting in the patients best interests especially when the drugs needed are useful to the patient and are expensive to the dentist; where the services given by the dentist are expensive for the patient to observe. The agent and the principal have different interest and asymmetric information. The problem arises mostly in cases where one party gets paid by another do something for them. Moral hazard issues and Conflicts of interest arise when the principal (patient) feels exploited by the agent and he might choose to withdraw from making any transaction, comparing the deal would have to be in both parties interest. This involves changing the rules so that the self-interested balanced choices of the agent agree with those of the principal desires.

Several mechanisms can be used to align the interests of the principal with those of the agent. In employment, employers (principal) may use performance measurement, profit sharing, commissions, efficiency wages and piece rates the agents posing a threat of termination of employment (Miller, 2005). The primary motivation of the workers comes through holding a partial stake in the company’s performance; profit-sharing in consideration leads to desirable outcomes, which ultimately increase the firm’s productivity

A recent research has shown that employee ownership promotes employees’ commitment to the firm. This, in turn, improves the ability of the company to execute several varieties of key strategic activities for instance, product development, market expansion and sale which results in profitability. Economists identified that investment in human capital is an important contributor to firm performance, though this usually undertaken with preset specific strategic objectives in mind. Human capital links to contribute to the common stock of skills and knowledge which benefits the entire a nation’s economy (Ownership, 2012).In cases when the staff understands the operations and owns the production or service, workers in many occasions could fail to see the overall business plan and objectives of the firm as viewed by the owner. The workers themselves may not agree on the direction for the company, or the employees could fail to understand the reason as to why the owners may refuse to inject more funds into the business operation. Hence, the workers who command power daily thinks the owner proposes less practical contribution, with the notion that they understand the company’s operations precisely.

In summary, the principal owner of a business cannot possess all the expertise required in the daily operations of the company, and hence there comes a need to out-source expertise. Both the employee and employer depend on each other, though the stake in the business might differ significantly (Seba, Allen & Fraser, 2010).

References

Grossman, S. J., & Hart, O. D. (2010). An Analysis of the Principal-Agent Problem Published by: The Econometric Society Stable URLs : http://www.jstor.org/stable/1912246, 51(1), 7–45.

Miller, G. J. (2005). 14. Solutions to Principal-Agent Problems in Firms, 349–370.

Ownership, T. H. E. E. (2012). Benefits and consequences, (July).

Seba, R. D., Allen, F. H., & Fraser, A. (2010). Economics of Worldwide Petroleum Production. USA: OCGI Publications,

Sanford , J., & Oliver, D. (1983). An analysis of the principal-agent problem. Econimical Journal of Econotrica Society, 51(1), 7-45. doi: 07/12/2010 13:06

 


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